My recent evidence to the House of Commons International Trade Select Committee on the economic effects of trade policy considers various options for UK financial regulation post-Brexit.
The main choice is between equivalence and mutual recognition – and this would cover both services and qualifications. However, in the absence of an agreed solution with the EU, there is growing support for World Financial Centre model, where the City goes it alone.
Enhanced equivalence model
A ‘third-country equivalence regime’ is permissible under the EU’s MiFID II legislation. This covers the entirety of investment businesses, including those of banks. There are also numerous other existing equivalence regimes for sectors of the financial services industry.
Barney Reynolds proposes an ‘enhanced equivalence’ model, under which the gaps in existing equivalence regimes are filled in and regulations are accepted as being sufficiently similar, but without actually being identical.
There would be two key issues to resolve during the Brexit negotiations: that the EU and the UK agree to treat each other fairly in assessing rules as being equivalent; and that they agree terms on which equivalence can be withdrawn without political interference.
Enhanced equivalence would allow the UK to remove the most unnecessarily onerous requirements of EU legislation (while maintaining equivalence determinations); move away from the EU’s process-focused approach to one based on outcomes; re-draft laws in common law style, which would bring with it far greater legal certainty; and move away from poor European Court of Justice decision making in the financial services context.
The EU has negotiated equivalence-based arrangements with the US for the most systemically risky portion of the market, clearing houses. Further, the EU is committed to free capital movement through the Maastricht Treaty, and the European Central Bank has signed up to the Bank for International Settlements rules on creating a level playing field for all providers of financial services.
The UK also supports these objectives. Further, in December 2017, the Prudential Regulatory Authority proposed permitting EU banks to convert to third-country branches in the UK.
A leaked draft of an annex to the EU’s Guidelines for negotiating a future trading relationship with the UK suggests the EU might be willing to offer ‘improved equivalence mechanisms’ to cover financial services. All of which suggests this model could work.
A different alignment concept is ‘mutual recognition’ through ‘mutual market access’. This achieves a similar result as enhanced equivalence, but assumes that financial services regulation and supervision in the UK and the EU would remain sufficiently aligned in the future. It would be jointly monitored by a Forum for Regulatory Alignment.
Many in the City prefer this model, with alignment defined solely in a free trade agreement. However, Lord Kerr, a former British Ambassador to the EU, didn’t see any such solution working, believing instead that only the current (unenhanced) equivalence option will be offered on the grounds that “the City needed to prepare for a deal that would ultimately hurt London’s standing as a global financial centre”.
Dual regulatory regime (Channel Islands model)
Jersey is not formally in either the UK or the EU. It has much lighter regulation than the EU, but offers an equivalent regulatory regime for firms that want to access the single market.
If the UK adopted a dual regulatory system, it would operate as follows in two parts. The ‘EU equivalence’ part: UK companies providing wholesale investment services would be able to do so only if they benefitted from the unfettered, unilateral equivalence determinations of the EU; alternatively, they would need to set up EU branches or subsidiaries to achieve this. The ‘UK and the rest of the world’ part: the UK would establish a regulatory framework that is best suited for UK companies operating outside the EU.
Special hybrid (Swiss insurance model)
This would be a bilateral arrangement that was better than equivalence but different from a passport (which is the current arrangement). It would be similar to the EU-Swiss deal on insurance.
Establish a fully capitalised subsidiary (Swiss banking model)
In this model, firms operate through subsidiaries. Such firms also use distribution or servicing hubs within the EU, such as Luxembourg or Dublin. However, this model is expensive, since each subsidiary has to be separately capitalised and there are limited opportunities to use capital more efficiently by netting and diversifying risks across different subsidiaries.
Multi-layered approach (Country-by-country model)
The Association of Investment Companies (which only conducts business in a subset of EU member states) supports a multi-layered approach to fund regulation once the UK leaves the EU. European rules would only be imposed if the funds were marketed within the EU.
The Investment Association has recently proposed that the UK Financial Conduct Authority should enter into Regulatory Cooperation Agreements (RCAs) with each of its EU27 counterparts.
The World Financial Centre model
Barney Reynolds recognises that the enhanced equivalence idea might not be acceptable to the EU, so the “UK should be ready to adopt the ‘go it alone’ World Financial Centre model…and design a more attractive regulatory framework, freed of the EU’s restrictive policy and process-driven approach, based on global standards”.
The UK can continue doing business in the EU even without single market access via passporting or an enhanced equivalence regime, by making maximum use of international law protections, including ‘reverse solicitation exemptions’ or ‘overseas persons exemptions’; existing EU laws that allowed cross-border dealings (‘including multiple on-the-ground visits’) without a local branch or licence; and human rights legislation that protects property rights under contracts between UK and EU27 businesses that existed prior to Brexit.
Earlier this month, the Institute of Economic Affairs issued a report on the financial services regulations that would be needed to support the World Financial Centre model. Freed from burdensome and costly EU regulations – equivalent to 2-3 per cent of the financial sector’s annual costs – Economists for Free Trade have estimated that the City would grow by £20bn over the next ten years under this model.
What’s the most likely outcome?
It is clear that the EU is not prepared for a completely tailor-made bilateral deal with the UK, so the only realistic options for a solution that both sides will accept are enhanced equivalence or mutual recognition.
However, in the absence of an agreement, the City is more than capable of going it alone – as it has done successfully for most of its history.
By David Blake, Professor of Economics at the Cass Business School and a Member of Economists for Free Trade. ‘Brexit and the City’ discusses a range of issues including: the City’s current relationship with the EU; the UK financial services industry’s advantages, vulnerabilities, threats and opportunities; and the various alternatives to passporting.